Tuesday, January 26, 2010

Federal Funds Targeting: The End of an Era?

For over two decades now, the federal funds rate has been the key operating target of monetary policy in the U.S., as the Fed manipulated the availability of reserves in the banking system, via open-market operations, to achieve a particular level of that overnight interbank rate. Since December 2008, courtesy of the financial crisis, that rate has stood close to o% (or, as the Fed officially defines its target "within a range of 0% to 0.25%).

With a massive amount of quantitative easing put in place since the onset of the most acute phase of the crisis in September 2008, and with the Fed already actively exploring various tools that can be used in the balance of the year to drain over $1.2 trillion of extra liquidity still slashing around in the banking system, it is increasingly likely that fed funds targeting will be taking back seat in that process, if it has any seat at all.

The massive amount of liquidity that will need to be taken out of the system when the time comes is simply not on a scale that routine, even if aggressive, open-market operations (Reverse Repurchase Agreements) can handle. In fact, a distinct risk exists that attempting to adhere to procedures that have been used in the past to address "run-of-the-mill" needs to drain reserves from the banking system in order to handle such a monumental and complex task ahead would cause the Fed to lose control of the federal funds rate and deliver a major blow to its own credibility.

The need to be creative and invent new techniques to accomplish that task has been increasingly at the forefront of the Fed's preparedness efforts in the last few months. For example, just last month, the Fed Chairman proposed that the Fed offer term deposits to banks in addition to the current regime where the Fed pays interest on banks' excess reserves and reserve requirements. The idea remains the same: the Fed needs to implement effective ways to tie up progressively large amount of bank reserves and prevent them from being actively used for excessive loan creation that could fan inflation pressures when the economic recovery is on solid footing and the banking system has regained a greater sense of stability. Open-market operations were well suited in the past to handle tasks that were far more moderate in scope, when the only easing that the Fed might have put in place was of the qualitative kind. Things are very different now and the inadequacy of such tools is a fairly transparent issue.

It is precisely that problem that Richmond Fed President Jeffrey Lacker was addressing in some remarks he made earlier this month, when he raised the issue that the Fed is considering the adoption of the interest rate they now pay on bank reserves as the new benchmark rate, replacing the concept of a fed funds target used until now (see link below).


The premise here is that the Fed feels more confident that they can achieve better control over the amount of bank excess reserves and lending by manipulating the interest rate they pay banks on their reserves compared to any attempt to control the fed funds rate by targeting non-borrowed reserves via open-market operations (which had been essentially the mechanism until a year and a half ago).

The whole project of managing to drain that huge amount of extra liquidity with reasonable efficiency, accuracy, and in an orderly fashion, is likely to be a pretty complex one and will inevitably include some glitches along the way, given the complete lack of precedent. But it looks increasingly likely that we may be at the doorstep of a major overhaul in the Fed's longstanding operating procedures in the conduct of monetary policy.

If the Fed does indeed usher in a new period where they express monetary policy actions in terms of the level of interest rate paid on bank reserves rather than a federal funds target, a significant prospect exists that the latter may slowly fade into oblivion- another casualty of the financial crisis.

Anthony Karydakis

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